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In day trading, the trader both opens and closes the same position within a trading day. Day traders trade for profit (Statman [2002]), and since day traders profit from relatively small intraday price moves, they are likely to use leverage to increase their profits. Even if day traders are relatively few in number--approximately 1% of market participants--they account for a relatively large part of the traded volume in the marketplace, ranging from 20% to 50% depending on the marketplace and the time of measurement (Barber and Odean [1999], Kuo and Lin [2013], Barber et al. [2014]). This suggests that leverage may be involved.
However, foreseeing how leverage will affect trading profit is not elementary. We know from the insights of Kelly [1956] and Thorp [1969] that the relation between profit and leverage is concave and that there exists a unique, optimal leverage factor that maximizes long-run profit (see also the results in Vince [1990]). The implication of optimal leverage is striking: that too small a leverage factor leads to a lower long-term profit than is feasible, but also that too large a leverage factor leads to a lower long-term profit than is feasible. The intuition is that a too-large leverage factor leads to severe drawdowns in capital, from which it takes too long to recover. Even though the leverage factor crucially affects trading profit, academic literature has largely ignored this effect. For example, the effect of leverage on day trading profit to the best of our knowledge has never been studied--a shortcoming we remedy in this article.
This article studies the effects of leverage on profit when trading a popular day trading strategy known as the opening range breakout (ORB) strategy. Introduced in Crabel [1990] to profit from intraday price trends in financial markets, the ORB strategy is used by allegedly profitable day traders (see, for example, Williams [1999] and Fisher [2002]), and academic studies by Holmberg et al. [2013] and Lundström [2013] confirm its profitability. The ORB strategy is based on the premise of intraday momentum in financial prices, so that if a price moves a certain percentage from the opening price level, the odds favor a continuation of the move until the market closes for the day. An ORB trader therefore enters the...